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The US stock market performed very well during 2013. The S&P
500®’s total return of nearly 33% far outpaced the returns of
most asset classes. Interestingly, the rally in US stocks
occurred despite a significant increase in longer-term interest
rates. The 10-year t-note hit a low of 1.6% in early May and rose
above 3% by year end.

We continue to believe that much of the bull market has followed
historical precedent despite the unusual magnitude of the
monetary and fiscal policy catalysts used in an attempt to right
the economy. Whereas some investors have suggested the stock
market should not be rising in combination with rising rates,
2013’s performance seems to us to be a normal mid-cycle rally in
which the unanticipated improvement in fundamentals typically
outweighs the negative effects of rising rates.

A growing contingent of market observers is fearful that the US
equity market is in some sort of a bubble. We disagree completely
with this notion. A strong market rally that many investors have
missed is hardly sufficient grounds for a financial bubble.

High beta stocks are undervalued

It seems to us that a necessary condition for an equity bubble is
the overvaluation of the stocks most sensitive to the overall
stock market’s movement. It seems very unrealistic that high beta
stocks could be selling at historically conservative valuations
if there really was an equity bubble underway.

Chart 1 shows the relative valuation of the stocks in the S&P
500® with the highest betas (i.e., those stocks with the highest
sensitivity to overall market movements) versus that of the
stocks with the lowest betas (i.e., those with the lowest
sensitivity). Despite claims that the equity market is in a
bubble, it is low beta stocks and not high beta stocks that are
selling at rich valuations. High beta stocks are actually close
to record conservative relative valuations.

Richard Bernstein Advisors

What constitutes a bubble?

In his wonderful book, Devil Take the Hind Most, Edward
Chancellor demonstrates that financial bubbles tend to follow
similar patterns. Most important, his work suggests that
valuation alone does not constitute a financial bubble. Financial
bubbles go beyond the financial markets and tend to pervade
society.

Our interpretation of Chancellor’s work is that there are five
common characteristics to a financial bubble. The US equity
market does not seem to match these characteristics. The five
characteristics are:

1) Available liquidity

2) Increased use of leverage

3) Democratization of the market

4) Increased turnover

5) Record new issues

One could certainly argue that the Fed’s extraordinary efforts to
stimulate the US economy have provided tremendous liquidity to
the financial markets. However, we find scant evidence that the
other four characteristics currently apply to the US equity
market. For example, many have noted that volume was weak during
2013, new issues were not rampant, and protection was more
important to most investors than using leverage to accentuate
performance.

But, isn’t the market’s PE ratio very high?

The absolute valuation of US equities is not cheap. However, the
market appears fairly valued if one accounts for interest rates
or inflation. After all, shouldn’t the PE ratio be relatively
high when inflation is less than 2%?

Chart 2 below shows the 12-month forward returns of the S&P
500® using combinations of valuation (defined using the
often-discussed Shiller “CAPE” Cyclically Adjusted P/E ratio) and
inflation. Although historical comparisons to the current
environment don’t suggest extremely high returns for the S&P
500®, it does suggest roughly “normal” returns.

Richard Bernstein
Advisors

PE-driven versus earnings-driven bull markets

Investors seem to be assuming that every bull market starts with
a low PE and ends with a high PE. However, history shows that has
not always been the case. There have actually been two types of
bull markets. Some have been PE-driven, meaning that interest
rates fall and PE multiples expand. Most of the bull markets
after 1980 fit this description. Other bull markets have been
earnings-driven, meaning that interest rates rise and PEs
contract, but earnings growth is strong enough to more than
offset the negative effects of rising rates and PE compression.
2003’s bull market would be an example.

We have always thought that the current bull market would turn
into an earnings-driven market, and 2013 fit that description. As
previously stated, interest rates rose during much of 2013, but
the unanticipated improvement in fundamentals far outweighed the
negative effects of rising rates. We expect this trend to
continue.

Skepticism doesn’t accompany bubbles

While there is no doubt that investors’ fears regarding equities
after the 2008 bear market have started to subside, this is a
normal occurrence for a mid-cycle environment. The euphoria that
is typically present at market peaks has yet to occur.

There are indeed financial bubbles around the world. Credit
growth in China would be a perfect example. However, we strongly
doubt that US equities should be added to that list.